I've been told the average rent for a house should be the house price, minus 3 zero's and that should be how much it should be a week, which I think works out to be about 5% of the house price per year.

Is that an accurate way to measure whether it is worth it to buy or rent?

5 Answers
5

Besides the long-term concern about which is cheaper, which has already been addressed by other answers, consider your risk exposure. Owning property has financial risks associated with it, just like owning stocks or bonds. The risk-related downsides of owning a home as an asset include:

It's often a very large investment. You would probably think twice before taking out a loan for hundreds of thousands of dollars to put into real estate investment trusts... Would you think twice about taking out the same loan to buy a single property?

It's not diversified. Its value is tied to the economy in your area. If the area suffers an economic shock, you might lose your job and your house will be worth less at the same time, possibly leaving you with an underwater mortgage.

It's indivisible. If you own stocks and need money, you can sell some of them. You can't just sell your spare bedroom to raise some quick cash.

It's illiquid. If you need to sell really fast, you're not going to get the best price. The transaction costs associated with buying and selling houses are quite high. Renting leaves you more flexible and able to move around the country (or the world) for career reasons.

The risk-related upsides of owning a home as an asset include:

It's a hedge against rising housing prices in an area. If you want to settle down and worry about being priced out of the area you live if rent rises, you're probably safer owning your house. This is especially relevant to people whose income is not tied to the performance of the local economy, especially those on a fixed income in retirement.

Taking on some risk can save you (or earn you) money in the long run (that's why people buy risky stocks, after all) but consider how well you're equipped to handle that risk before you rush out to buy on a naive analysis of what's cheaper.

+1 the description of risk-exposure vs a "naive analysis of what's cheaper" is a very important counter point.
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yhw42Sep 12 '10 at 22:28

3

"You can't just sell your spare bedroom to raise some quick cash." No, but you can rent it out to someone and generate some revenue that way (which comes with the added risk and inconvenience of having someone share the house with you).
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Justin ScottSep 13 '10 at 13:19

The Motley Fool suggested a good rule of thumb in one of their articles that may be able to help you determine if the market is overheating.

Determine the entire cost of rent for a piece of property. So if rent is $300/month, total cost over a year is $3600. Compare that to the cost of buying a similar piece of property by dividing the property price by the rent per year. So if a similar property is $90,000, the ratio would be $90,000/$3600 = 25.

If the ratio is < 20, you should consider buying a place. If its > 20, there's a good chance that the market is overheated.

This method is clearly not foolproof, but it helps quantify the irrationality of some individuals who think that buying a place is always better than renting.

Additionally, Alex B helped me with two additional sources of information for this:
Real Estate is local, all the articles here refer to the US housing market. Bankrate says purchase price / annual rate in the US has a long term average of 16.0. Fool says Purchase Price/Monthly Rent: 150 is good buy, 200 starts to get expensive

This answer is copy pasted from a similar question (not the same so I did not vote to merge) linked here..

have you got the link to the article? Why 20? I would like to get an understanding of where these figures come from
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Joe.ESep 17 '10 at 0:51

@RoboShop - I stated in my original post (on the similar questino) I don't quite remember where the article is which stated the #20. For more detailed info its best for you to look at the bankrate and fool articles at the bottom of my post.
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CrimsonXSep 17 '10 at 14:43

had a read, wow given that it was published in 2005, seems very prophetic now...
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Joe.ESep 19 '10 at 22:25

No magic answers here. Housing is a market, and the conditions in each local market vary.

I think impact on cash flow is the best way to evaluate housing prices. In general, I consider a "cheap" home to cost 20% or less of your income, "affordable" between 20-30% and "not affordable" over 30%.

When you start comparing rent vs. buy, there are other factors that you need to think about:

Is it a tight rental market? Easiest way to tell this is to compare the costs of ghetto apartments to nice apartments. Government housing subsidies are based on prevailing rent, so when a two-bedroom in the hood is over $1,200, you have a hint that rents are high in the area.

Is it a tight home market? Do sellers expect written offers within hours of you looking at the house? If so, you are paying too much.

What landmines are out there in terms of risk as a homeowner? Is the city and county well-run in general? Is there a large police and paid fire department? Do the schools suck? Is the local government on a bonded public works building spree?

Are you dependent on an HOA to provide basic services? (Sewer, water, etc) Are you willing to participate in the HOA and argue with people?

What are your income prospects for growth and stability? Are you a construction worker on unemployment during the winter? Do you have a moderate pay/low risk government job? Are you a salesman?

Renting is an easy transaction. You're comparing prices in a market that is usually pretty stable, and your risk and liability is low. The "cost" of the low risk is that you have virtually no prospects of recouping any value out of the cash that you are laying out for your home.

Buying is more complex. You're buying a house, building equity and probably making money due to appreciation. You need to be vigilant about expenses and circumstances that affect the value of your home as an investment. If you live in a high-tax state like New York, an extra $1,200 in property taxes saps over $16,000 of buying (borrowing) power from a future purchaser of your home. If your HOA or condo association is run by a pack of idiots, you're going to end up paying through the nose for their mistakes.

Another consideration is your tastes. If you tend to live above your means, you're not going to be able to afford necessary maintenance on the house that you paid too much for.

I'm confused about one thing--can you explain this a bit more: "an extra $1,200 in property taxes saps nearly $20,000 of buying power from a future purchaser of your home"?
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PeteSep 15 '10 at 21:21

I made a typo. When looking for a mortgage, $100,000 at 6% costs you $600/mo. $100/mo more in property taxes means the potential borrower effectively loses about $16,600 in borrowing ability. Where I live in NY, mismanagement on the part of the school district and NY state has raised my taxes over $700/year over what I paid in 2006.
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duffbeer703Sep 15 '10 at 22:13